Changes in real wages are an important vehicle for an economy’s adjustment to shocks. Discussions on the development of wages during the business cycle, therefore, have a long history going back to Keynes (1936) and beyond. Up to the early 1990s, most macroeconomists believed in evidence from aggregate time series showing that real wages were quite stable over the business cycle. However, Solon et al. (1994) demonstrated that the true movement of real wages is not visible in aggregate data due to a (countercyclical) composition bias. Studies based on micro data found that wages actually change in a procyclical way, and that wage cyclicality differs between demographic groups. In a recent study (Gartner et al. 2012) we show that wage adjustments to positive and negative economic shocks are generally not symmetrical, and that the degree of wage adjustment also depends on whether or not a plant applies a collective bargaining agreement. In contrast to conventional wisdom, it turns out that collective bargaining does not cause downward wage rigidity in times of rising unemployment.

We analyse the role of collective wage bargaining and works councils for wage adjustments during the business cycle by using a large-scale linked employer-employee dataset for western Germany (our dataset comprises about one million observations). We focus on wage changes of employees working in the same plant in two consecutive years. As indicators for the economic situation we use changes in regional rates of unemployment. The period of observation is 1995 to 2004 and covers more than one complete business cycle. The period 1995 to 1997 was one of economic weakness with rising unemployment. Due to the new economy boom, unemployment was falling between 1997 and 2001. With the burst of the new economy bubble in 2001, unemployment started to rise again.

We pay special attention to the German system of industrial relations, which is characterised by a dual representation, including:

Works councils. Work councils are mandatory, but not automatic, in all establishments with five employees and have extensive rights of information and consultation on issues such as planned structural alterations to the plant and manpower planning. In addition they have co-determination rights on what are termed ‘social matters’. These extensive rights give works councils some bargaining power although formally they are not allowed to bargain about wages. In plants with at least five employees, around half of the workforce is represented by works councils.

Trade unions. Trade unions bargain over wages either at the sectoral or at the firm level. The resulting collective agreements cover 66% respectively 8% of the workforce.

Since there are also firms without collective bargaining and/or without works councils, six possible regimes of industrial relations in a plant exist.

Any cyclical adjustment in the observed earnings may occur due to changes in the hourly wage or in the hours worked. From a worker’s point of view, total income matters more than the hourly wage rate. Thus we analyse daily earnings instead of hourly wages. Figure 1 presents the development of wage changes (as log differences) separately for the different regimes. As expected, wage growth is higher when unemployment is falling and lower when unemployment is rising, but at first glance there is no clear pattern concerning differences across regimes.

Figure 1. Development of real wage changes in different industrial relation regimes

Note: Wage changes are changes between two consecutive years in log wages.

Source: LIAB, own calculations.

Most studies on wage cyclicality assume that the wage reaction on falling unemployment is as strong (and of opposite sign) as the reaction on rising unemployment. When we impose this symmetric wage reaction, we cannot identify differences in wage cyclicality according to industrial relations regime. However, when relaxing this restrictive assumption, the prevailing bargaining regimes do matter. This is shown in Figure 2, which provides a simulation of the reaction of real wages to a change in the unemployment rate. We have generated these wage developments with the coefficients (irrespective of whether they were statistically significant or not) obtained from estimating the wage growth of individual workers on the change in the unemployment rate, thereby controlling for gender and non-German citizenship, potential work experience, educational attainment and ten categories for occupational status, for sectoral affiliation and establishment size classes.

Note: Simulation of the reaction of wages (change between two consecutive years in log points) to a change in the unemployment rate (in percentage points).

For all industrial relations regimes, the adjustment in wage growth to falling unemployment is stronger than to rising unemployment. More precisely, falling unemployment leads to a higher wage growth across all industrial relations regimes, but this relationship is stronger in plants with individual bargaining than in plants with sectoral bargaining.

Surprisingly, if unemployment rises, wage growth is only reduced if wages are bargained at the sectoral or firm level, whereas there is clear evidence for downward wage rigidity if wages are bargained individually (i.e. wages do not react to changes in the unemployment rate). This contrasts with the Keynesian view that unions prevent wage cuts. An explanation for downward wage rigidity in plants without collective bargaining could be employers’ strategic personnel policies such as preventing costly fluctuation and holding up worker motivation and productivity. Wage cuts may be assessed as unfair by workers and reduce their motivation. As a consequence, efficiency wages and fairness considerations lead to downward wage rigidities even in the absence of labour market institutions (see Bewley 1999).

At first sight, one might wonder why such fairness considerations are absent under collective bargaining. An explanation may be that, in Germany, opening clauses in collective contracts allow firms to deviate from sectoral agreements in order to secure jobs (see Addison et al. 2007). In addition, more than 40% of plants covered by collective agreements pay wages above the level stipulated in the agreement and these so-called wage cushions can easily be reduced if the economic situation worsens (see Jung and Schnabel 2011). For these reasons, workers may even regard lower wage growth in the face of rising unemployment as fair in regimes with collective bargaining.

Interestingly, for all three bargaining levels the impact of a change in the unemployment rate on the development of wages is unaffected by the existence of a works council. This is directly implied by observing that the slopes of the lines between regimes 1 and 2 respectively between 3 and 4 respectively between 5 and 6 do not differ. At the same time, it should be noted that the paths for individual bargained wages (regimes 1 and 2) are almost identical, i.e. it does not matter whether or not a works council exists. By contrast, we find that works councils increase wage growth in combination with sectoral bargaining (the path for regime 6 is on a significantly higher level than for regime 5). This suggests that establishment-based works councils cannot (and do not) serve as substitutes for sectoral trade unions.

Conclusions

To a large extent, our empirical findings do not support the theoretical assumption from Keynesian models that labour market institutions like collective wage bargaining cause downward wage rigidity in times of rising unemployment. We do find downward wage rigidities in the absence of collective bargaining. It is sometimes believed that collective wage contracts in Germany lead to higher wage levels, but according to our findings collective bargaining cannot be blamed for causing wage inflexibility during the business cycle.